Last week was another decent week for equity markets as headline U.S. economic data suggested a sharply improving economy. While a more careful look at the data was not as bullish, fears of a U.S. recession seem greatly diminished.
Central bankers continued to suggest that more easing was likely in the months ahead and that soft export data out of China could mean more stimulus in that market. That tends to handcuff the U.S. Federal Reserve from raising rates, even as the U.S. economy accelerates and inflation worsens.
Academic economists often study past Fed actions surrounding bouts of inflation and conclude that the Fed was asleep at the interest-rate switch, or at least too slow to act. They ask how this can happen again and again.
Right now, we are seeing exactly how and why that happens. There are factors, often different each time, that cause them to pause. This time it is the world economy. Beyond world activity, even the modest rate rise in December seemed to coincide with a slow first quarter, which is making the Fed doubly cautious concerning further increases. And when volatile economic data intimates a recession one month, and then shows a boom the next month, who can blame them?
The quick summary of recent data suggests the consumer is back in the saddle after a rough first quarter, inflation continues to worsen especially in services, and manufacturing, despite some fancy headlines, remains stuck in the mud. Given labour shortages, employment growth is going nowhere fast.
Retail Sales Data Suggests the Consumer Is Alive and Well
Consumption represents about 70% of GDP and retail sales of goods comprise about a third of consumption. In recent quarters, almost all GDP growth has come from consumption. A sharp drop in consumption in the first quarter was the main reason GDP growth dropped to a pathetic 1.1% growth rate. Unusually warm weather and auto industry results played a big role in that drop.
Now it appears that as weather has returned to normal so has consumer spending. With China, Brexit, and terrorism headlines in the paper every day, there was a lot of fear that consumers would pull in the reins in June after opening up their wallets in April and May. Poor June auto sales heightened those fears.
However, the June retail sales report was much stronger than anybody anticipated. Headline retail sales grew at a 0.6% rate, 0.7% excluding the suffering auto industry. This compared with embarrassingly low consensus forecasts of 0.1%. The strong June results followed strong gains of 0.2% in May and 1.2% in April. Usually retail sales bounce around from month to month with good and bad months often alternating. Three decent numbers in a row is quite unusual.
Inflation Not as Benign as Headline Numbers Suggest
Markets were very satisfied with the June CPI report with headline and core inflation of just 0.2%, 2.4% annualised, which exactly matched consensus forecasts. Headline total inflation was just 1% year over year, while core inflation did heat up modestly to 2.3% for the single month of June. The year-over-year trend in both total and core didn't move that much month to month, which many investors found soothing.
Stepping back, the 12-month trend is clearly worsening as energy prices stabilise and services prices accelerate. Falling food and hard-goods prices have kept a lid on inflation for longer than we had been expecting.
Services Remain a Huge Issue
Beneath the surface, service inflation, perhaps driven by higher wages, has accelerated at an alarming rate. The three-month average of services inflation is now up 3.2%, the highest level of the recovery. With services accounting for about 60% of the CPI calculation, this certainly is not a good thing. As we discuss later, a broad range of services prices has been accelerating.
